Commentary: Dodd-Frank shouldn’t end swaps at year end

Federal regulators roiled farmers across America with the release of new rules for financial instruments on Aug. 27. The Commodity Futures Trading Commission, one of the agencies charged with implementing the Dodd-Frank Wall Street Reform Act, officially announced the new requirements and said they would take effect by year’s end.

What does Dodd-Frank, passed in response to the 2008 economic crisis and aimed at reforming a vast swathe of the financial sector, have to do with farmers?

Among the instruments covered by the commission’s new proposals are agricultural commodity “swaps.” Basically, swaps empower farmers, ranchers, agribusinesses and other food suppliers to hedge against certain risks common to their trade, like bad weather or a crash in the price of a food item they sell.

Swaps might sound like they serve some distant, exotic purpose far removed from the lives of average Americans. But they play a key role in providing food producers with a basic level of financial security through tough times, which helps to ensure price stability for consumers.

Consequently, the way the commission imposes Dodd-Frank rules on these instruments will have a profound effect on Americans’ pocketbooks. And right now, all signs indicate the commission’s approach to implementing Dodd-Frank is going to inadvertently smother agricultural swaps with over-regulation.

In the rush to prevent another crisis, it has cast its net too wide. As a result, Dodd-Frank could make risk management significantly more costly for America’s farmers, driving up volatility in the market and potentially leading to huge price increases for consumers.

The commission’s new rules affect agricultural commodity swaps that aren’t sold on exchanges and don’t run through third-party intermediaries — so-called “over-the-counter” swaps.

Consider a bread baker in Kansas City. He buys thousands of pounds of flour each year. Because of this year’s droughts, though, he’s worried that America’s wheat supply will shrink, driving up flour prices over the next 12 months.

So, to hedge against a price spike, he buys $10,000 in over-the-counter flour swaps today to guarantee that next year he can purchase 10,000 pounds of flour for $1 per pound. In 12 months, if the price of flour is dramatically higher, he’ll have saved himself a huge amount of money. The price could also be lower, of course, but that’s the risk he runs in order to guarantee he won’t go bankrupt.

Right now, over-the-counter agricultural swaps are mostly unregulated. But that shouldn’t be a point of concern. These instruments had nothing to do with the financial meltdown.

Nevertheless, this new round of Dodd-Frank rules would impose a slew of new requirements on these instruments. Buyers and sellers would have to trade them on approved exchanges, and they would need to have a certain level of capital on hand to trade. Reporting rules regarding profits and losses would be ratcheted up.

There would also be mandatory “clearing,” meaning swap trades would be required to run through certified middlemen. This is a particularly backward idea.

The over-the-counter agriculture swap market has been running safely and efficiently for years without mandatory middlemen. No one — not even the regulators charged with implementing Dodd-Frank — claims otherwise.

On the other hand, the traditional futures market operating under mandatory clearing rules has been home to some of the biggest financial meltdowns of the last few years. About a billion dollars evaporated before the brokerage firm MF Global declared bankruptcy in October 2011. And Peregrine Financial had racked up a $200 million shortfall in customer funds before it was forced to shut down in July.

The clearing rules regulators are so eager to foist on over-the-counter agricultural swaps were in full force for both MF Global and Peregrine. And yet, the system still suffered massive losses. This regulatory structure is obviously broken.

So, implementing Dodd-Frank as planned means forcing agriculture swaps to move from a regulatory environment that is universally acknowledged to be working well to one that has failed repeatedly to prevent fraud and abuse.

That’s just senseless.

Over-regulation can be just as dangerous and costly as under-regulation. And in this case, these invasive Dodd-Frank rules could dramatically drive up operation costs for farmers, ranchers and others involved in food production. The rise in expenses would, in turn, be passed along to American consumers in the form of higher food prices.

Some farmers would no doubt be driven out of the swaps market altogether.

With no way to manage financial risk, the next hurricane or tornado could put them out of business.

At the very least, regulators need to give themselves more time to study this issue by installing a three-year moratorium on the Dodd-Frank rules governing agricultural commodities. Blindly marching ahead and imposing strict new requirements on these instruments would wind up doing substantially more harm than good.